View From The Top: Until something breaks
View from the very top: Nobody ever said it would be easy. There have been few places to hide in mainstream asset classes (ex mega-cap tech equities). We also doubt whether things will change markedly in the near-term – or until something breaks. The reality is that it is hard to have a definitive view on either growth or inflation at present. Over a decade of unconventional monetary stimulus (from the end of the GFC to the end of the pandemic) cannot be unwound overnight. Similarly, how and when recent interest rate hikes will impact the economy is also unclear. We believe that a recession and an associated credit crunch are probably inevitable. Both consumers and businesses are facing refinancings just as lending standards are being tightened. Financing wars is also not cheap. In this uncertain environment, stick to what matters and do not let emotions dictate investment decisions. Allocate judiciously and unemotionally. Diversify yet preserve cash. Use drawdowns as opportunities.
- Equities: Choose carefully. This is a concentrated and distorted market. The rally witnessed since last October’s nadir has been the weakest in post-War history. Fewer than 30% of S&P 500 stocks are beating the Index year-to-date, while around 10% of constituents are at 52-week lows (per Bloomberg). Although the current earnings season is not finished, misses have been punished more than beats rewarded. Bottom-up FactSet estimates assume a fourth consecutive quarter of negative year-on-year earnings growth for Q3 2023. 2024 estimates are also at risk, if rates do stay higher for longer. Mega-cap tech stocks may offer some defensive merits (given their cash generation), but this needs to be balanced against valuation expectations. US small caps and non-US regions (especially Japan) offer opportunities for longer-term investors.
- Fixed Income/Credit: Bonds are experiencing their longest bear market in history. The ~50% drawdown in the iShares 20+ Year Treasury Bond ETF (TLT) is comparable to the meltdown witnessed in the 2008 stock market crash. Yields across the curve are at their highest since the GFC. While bonds look oversold on many metrics, it is harder to know what the near-term catalyst would be to reverse this dynamic. Looking longer-term, credit opportunities will emerge, when the bubble bursts, and with default rates increasing.
- Gold and Commodities: We see an important role for these assets in portfolios. They represent a valid hedge against mainstream asset classes, acting as a buffer against market volatility. Geopolitical uncertainties should also provide support for gold and oil in the near-term.
- Alternative Assets: Owning assets with collateral-based cashflows brings diversification to portfolios and acts as a hedge against inflation. We favour being selective across this broad and diverse area, favouring businesses with strong balance sheets, reasonable valuations and dividend yields.
- Cash: With a 5%+ yield, holding cash avoids commitment and provides a clear return. No surprise then that over $1tr has flowed into money markets year-to-date. Keep some dry powder for tactical and opportunistic deployment.
- Currencies: Dollar strength may endure near-term given both higher yields and its defensive qualities.
Headlines can be misleading. Anyone reading the popular press might almost believe that 2023 has been a good year for investing. Think about it – global equities are up around 6%. If you’d owned the NYSE FANG+ Index, you would have made more than 60%, while NVIDIA, AI’s poster child, has returned close to 180% year-to-date. Dig a bit deeper, however, and the story looks much less appealing. Strip out the so-called ‘Magnificent Seven’ US mega-cap tech stocks, and global equities are down year-to-date. Small cap indices are negative for the year. Over in the world of fixed income, things are markedly worse. Ten-year US Treasury debt has seen its biggest drawdown in over 100 years. Assuming no marked reversal before year-end, three consecutive years of negative returns in conventional fixed income is unprecedented in modern history. 2023 has been challenging, with few places to hide in mainstream asset classes.
We doubt it will get any easier in the near-term. This is not to say that we lack investment ideas (diversification, gold, commodities, certain truly differentiated equity and credit strategies), but more a recognition of the exceptionally challenging and uncertain macro environment. Without even considering the unfortunate impact of heightened geopolitical uncertainties and war in some regions, the reality is that it is hard to have a definitive view on either growth or inflation at present. Jerome Powell, Chair of the Fed, acknowledges as much. He, and we all, remain ‘data dependent.’ However, over a decade of unconventional monetary stimulus (from the end of the GFC to the end of the COVID pandemic) cannot be unwound overnight. Similarly, how and when over 500 basis points of US interest rate hikes in the last 18 months will impact the economy is also unclear.
That bonds and equities have decoupled is clear. Rising geopolitical risks and a relatively dovish Federal Reserve should have been positive for fixed income investors. Similarly, more elevated global uncertainties and higher real yields ought to have offered support to equity bears. However, both camps have suffered. Yields have moved higher and risky assets (or at least mega-cap growth equities) have remained resilient. Fiscal expansion and (the drawdown of) excess savings in the US provide the best explanation for why equities multiples have been sustained and bonds have been depressed. Spending is not slowing and neither is the US economy. Of course, for how long these dynamics can endure is unclear.
For investors, the certainty they want most of all – where we are in the interest rate cycle – remains elusive. Sure, we are closer to the end than the beginning, but it is far from clear when the Fed’s job is done. While inflation has receded, it remains too high. Getting back to 2% could take a very long time. Recent reports show that core inflation is rising again, while consumer expectations (per the University of Michigan survey) now point to higher inflation in both the near-term and longer-term relative to a month prior. The Fed’s dilemma is a hard one. If it does too little, inflation may become entrenched. At the same time, if it does too much, it may do unnecessary harm to the economy.
It is probably fair to recognise that investors should not count on the Fed to use either actions or words to reverse the run-up in long-term rates unless there is clear evidence that its policy is causing damage – or, until something breaks. At the same time, it is maybe unfair to attribute too much responsibility to the Fed. There are many moving parts. The US Central Bank clearly does not control either the future path of budget deficits or the correlation between stocks and bonds.
What we do know is that a recession is inevitable at some stage. The business cycle has not been abolished. Importantly, high long-term rates will themselves slow the economy and should keep the Fed from hiking too aggressively. 10-year inflation break-evens (i.e. the difference between the nominal yield on a fixed rate investment and the real yield on an inflation-linked investment) are now back at the same level they were in March, when Silicon Valley Bank failed, precipitating a regional banking crisis. At the same time, 30-year mortgage rates are the highest since 2000, while a 48-month new car loan is at its highest since 2001 (over 7.5% and 8.0% respectively). Average credit card rates of 21% are their highest this century.
No surprise then that fewer Americans are applying for a mortgage than at any time since 1997, while existing home sales are their weakest in 13 years. Credit card delinquencies are back at pandemic levels (all data per Bloomberg). When the New York Fed recently asked respondents to a survey whether it would be easier or harder to come by credit in the next year, the percentage responding with the latter was the highest since the survey began a decade ago. A credit crunch may be coming. These dynamics also help explain why small cap equity indices are underperforming, since smaller companies are typically more exposed to rising interest rates than larger ones.
Many market participants, we sense, are still living in a debt dreamland. The crude reality is that both consumers and businesses are facing refinancings just as lending standards are being tightened. Speculative grade companies in the US have almost $2tr of debt falling due in the 2024-2028 period, up 27% from the prior four-year period. Next year will mark the largest refinancing for high-yield issuers since the GFC. A record $1.26tr of corporate debt is also due for refinancing. Even if rates are now lower and debt quality is better relative to the last financial crisis, the default rate cycle is just getting started. Since 2010, the average US corporate default rate has been 2%, but this rose to 3% in the 12-month period ending July and could hit 4.5% by the end of 2024. For high-yield, the rate could peak at 9% (all data per Moody’s). A prolonged recession would certainly create an ugly credit aftermath in both public and private markets.
Financing wars is also not cheap. Treasury debt issuance year-to-date has been the second highest on record. This perhaps provides another explanation for why bond yields are moving higher – sure, we (investors) can finance you (the US Government), but it will come at a price. At 6% of GDP, the US federal budget deficit already stands at a level typically associated with recession. This is ironic, given recent economic strength. Demographic developments (more Medicare, Medicaid and Social Security disbursements) combined with ongoing interest payments mean that the deficit will hit 10% of GDP by the middle of the century, per the US Congressional Budget Office. Current interest payments on the deficit equate to $900bn, a doubling in the last decade. For context, the total budget for the Department of Defence in 2022 was $700bn.
Whether we like it or not, the direction of travel is towards a more all-encompassing set of geopolitical dynamics. A continued shift towards nationalism, protectionism and multipolarity further exacerbates macro challenges. Expect more grey swans (and perhaps some black ones too). Such an outcome would argue for a higher premium on traditional risk assets. Geopolitical uncertainties also increase the risk of a potentially synchronised global economic slowdown in 2024. At the same time, the failed predictions of most economists and strategists regarding both growth and inflation have left investors with even less faith and even more adrift of what’s coming next.
In such an uncertain environment, it’s important to stick to what matters and not to let emotions dictate investment decisions. Allocate judiciously and unemotionally. Forget TINA (there is no alternative – to equities) and consider TARA (there are reasonable alternatives). Diversify yet preserve cash. Use drawdowns as opportunities.
Alex Gunz, Fund Manager, Heptagon Capital
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